Should grandparents open a 529 savings plan to help with college costs?

With the steep cost of college, lots of grandparents feel the need to help cover some of the expenses.

One way to assist is by contributing to a tax-advantaged 529 college-savings plan. Earnings in the account are tax-free if used for qualified expenses.

But for grandparents, there can be a catch to your generosity. The Free Application for Federal Student Aid (FAFSA) looks at income and assets to determine how much parents and a student can contribute to their education expenses.

A 529 owned by a grandparent doesn’t get reported on the FAFSA. However, once funds are withdrawn and used to pay for college expenses, it’s considered income to the student and has to be reported the following year on the FAFSA. With this additional nontaxable income, the student may qualify for less financial aid.

Following my recent column on what people get wrong about 529 plans, a number of readers had some questions and comments, including one from a grandparent angry that his grandchildren’s financial-aid eligibility might be affected by his savings for them.

“I’m a grandparent and started 529 plans for all my grandchildren, thinking this would be a good way to help some of our adult kids who were struggling,” one reader wrote. “We received an article from our daughter that said grandparents’ 529s are counted as direct income for the grandchild and carry a 50 percent penalty against aid. We are not happy and feel we were sold a bill of goods by the financial industry, which touts them as the thing to do for your grandkids.”

There’s no nefarious intention here. The purpose of the FAFSA is to figure out which families are in the most need of financial assistance. As a grandparent, you shouldn’t feel bad that by doing the right thing your generosity may reduce assistance for your grandchild, because there’s a good chance a lot of that aid comes in the form of student loans, which your grandchild would have to eventually pay back anyway.

And there is a fix for this issue: Contribute to a parent-owned 529 plan. Money in a parent-owned 529 only reduces eligibility for need-based financial aid by a maximum of 5.64 percent of the net worth of the assets.

“As a grandparent, if you are willing to give up control of the funds, making gifts to an account opened by the child’s parent is generally preferable for aid,” said Roger Young, senior financial planner for T. Rowe Price.

Be sure to check with the financial company managing the 529 plan to make sure you can transfer ownership.

Here’s something else to consider: A recent change in the timing of federal-aid calculations may help a little, Young said. The FAFSA is now based on income from two years ago. For example, federal aid for the 2018-19 school year is based on your 2016 tax return.

“So, if your grandchild is entering college now and expects to graduate in 2022, withdrawals from your 529 account in 2020 and beyond would not affect financial aid in the first four years of college,” Young said.

Here are some other questions raised by readers:

Q: We have been looking into 529s for two grandchildren. We have looked at the Maryland 529, as we and our grandchildren currently live in Maryland. But we have also reviewed the Vanguard 529 from Nevada. Which would allow the most benefits and flexibility?

The myth that investing in a certain state’s 529 plan limits where a student can go to college just won’t die. Where you open an account does not curtail your choices.

But in deciding which plan to choose, consider several factors, including investment options, fees, customer service and any state tax benefits, according to Young.

Savingforcollege.com has a great tool to compare state plans. Look under the “529 plan” tab on the homepage.

Q: I wondered if I would be better off transferring money from my Thrift Savings Plan (the federal government retirement plan) into a 529 for my youngest child. She is a high school junior.

“Be careful about using retirement plan accounts for college,” Young said. “You may face taxes and penalties. And while a 529 has advantages, an account for a high school junior won’t have much time to benefit from tax-free growth.”

Just a reminder: There is a 10 percent penalty for early withdrawals from a workplace retirement plan if you are under 59 1/2.

Q: How much should we be saving each month? We have just been doing $100 a month for each of our daughters’ accounts. I just don’t know if that is enough.

“General guidelines can be very misleading,” Young said. “The answer depends largely on the type of school, your prospects for financial aid, and your priorities.”

How much you need depends on where your child goes to school. The average published cost for in-state college tuition, room and board was $20,770 for the 2017/2018 academic year, according to the College Board. It was $46,950 for a private college.

There are a number of online calculators you can use to help you figure out how much to save. Try a few of them, including the “college savings planner” tool at troweprice.com.

The hope for financial aid shouldn’t stop a parent or grandparent from saving for college. Despite some limitations, I believe that a 529 is still a good way to go.

Michelle SingletaryMichelle Singletary writes the nationally syndicated personal finance column The Color of Money. Her award-winning column is syndicated by The Washington Post Writers Group and is carried in dozens of newspapers nationwide. Follow